A New Kind of Future(s)

SOME PEOPLE have too much of a good thing: The 2001 tech wreck taught a lot of advisors and their clients that. In fact, no advisor worth his salt would suggest that a bond fund, a small-cap fund and exposure to, say, the 10 industry segments of the S&P 500 is all you need to smooth out a rocky equity market.

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SOME PEOPLE have too much of a good thing: The 2001 tech wreck taught a lot of advisors and their clients that. In fact, no advisor worth his salt would suggest that a bond fund, a small-cap fund and exposure to, say, the 10 industry segments of the S&P 500 is all you need to smooth out a rocky equity market. Unfortunately, many of the asset classes that are uncorrelated to the S&P 500 weren't readily accessible to retail investors six years ago.

Take commodities, for example. Until recently, direct commodity exposure could only be obtained through a futures account, an inconvenience for both client and advisor. Commodity-oriented mutual funds or mining stocks, because they are equity investments, often fail to provide pure commodity exposure; in fact, they often simply add more stock exposure. But now, novel investment contracts known as “total return asset contracts” (TRAKRs) can provide affordable and pure exposure to commodities as well other asset classes for the retail crowd. TRAKRs were developed by Merrill Lynch and are traded on the Chicago Mercantile Exchange's (CME) electronic Globex platform.

A Future — Sort Of

TRAKRs themselves are futures contracts, but are very different from traditional commodities contracts in that buyers don't use leverage. Margin rules allow futures speculators to control commodities worth 30 times the amount invested — and sometimes more. Unfortunately, the prospect of making $30 for each $1 invested when the odds are favorable can translate with alarming speed into losing $30 for each $1 invested when the odds are unfavorable.

It's here where TRAKRs most radically differ from traditional commodity contracts. TRAKRs don't expose retail buyers to the overhanging threat of mark-to-market margin calls. Paid in full like cash-settled stock purchases, long TRAKRs are unlevered (though short positions are margined at a Reg T-like 50 percent). The ante is small: Each TRAKRs contract is launched at a very stock-like price of only $25. And, TRAKR maturities are longer than most traditional futures. Stretching out as far as four-and-a-half years, TRAKRs have turned futures investing into buy-and-hold portfolio assets.

Better still, TRAKRs can be traded inside a securities account; no futures account is required. That means no Series 3 exam for the executing brokerage representative, no additional registration for the firm and no account-opening rigmarole for the client. All that's required to trade TRAKRs through existing securities accounts is “notice registration” of the executing broker and online training of its representative through the auspices of the National Futures Association, the self-regulatory organization for futures brokers. Brokers must also have access to the CME Globex quotation and trading platform, of course.

The underlying asset for each TRAKR is actually a proprietary index rather than a physical commodity. Unlike traditional index futures, though, TRAKRs' prices represent the total return derived from owning the underlying assets. The PIMCO Dow Jones-AIG Commodity TRAKRs, for example, represents a portfolio of diversified commodity futures and a fixed-income component. (Despite the inclusion of interest-paying assets in the underlying index, TRAKRs do not pass taxable distributions through to holders.)

A Less-Taxing Investment

Another essential difference between TRAKRs and conventional futures is their tax treatment. TRAKRs' tax treatment may be their greatest attraction. TRAKRs owners qualify for long-term capital-gains treatment after only a six-month holding period. Gains in conventional futures contracts are treated as 60 percent long-term and 40 percent short-term, adding up to a blended 23 percent tax rate.

TRAKRs' tax treatment also gives them an edge over exchange-traded funds, which must be owned for more than 12 months to be considered long-term holdings. “For advisors desiring commodity exposure for their clients, that's a great advantage,” says Tom Lydon of Global Trends Investments, an RIA in Newport, Calif. “A commodity trend lasting only eight months can receive long-term capital-gains treatment with TRAKRs. It'd be a short-term gain or loss for an ETF.”

For clients in Ron Hughes' business, that's a mighty big deal. Hughes, a senior vice president in Merrill Lynch's private client business in Atlanta, deals with ultra-high-net-worth customers. With an average of $10 million to $40 million in liquid assets, Hughes' clients are very tax-sensitive.

“The Rogers International Commodity Index TRAKR (RCI) was launched in late 2005 at $25,” he recalls. “In just a few short months, RCIhad risen to $28. RCI investors could have captured the commodity market's surge as a long-term gain while investors holding other commodity assets would have had to wait.”

TRAKRs' tax advantages can even make up for their high cost. The expenses embedded in the RCI TRAKR are 195 basis points (1.95 percent); an equally broad ETF based on the Goldman Sachs Commodity Index carries an expense ratio of only 75 bps. With the TRAKR, an investor in the 35 percent tax bracket could keep 30 percent more profit from a seven-month trade because of the differential tax treatment.

Exposing Too Much?

But, not every one thinks TRAKRs are worth it. Regardless of costs and taxes, the fundamental question is whether to bother with commodity exposure at all. The argument for low correlation isn't enough to interest Rick Ferri, a fee-only advisor in Portfolio Solutions in Troy, Mich., interested. “There must be the expectation of a real long-term return from the investment,” he says. “Commodities have historically generated less than a zero-percent real return. Stuffing money in a mattress has no correlation with stocks or bonds, but I don't recommend that either.”

But, those who seek low-correlation with the equity market and capital appreciation that beats a mattress' returns might want to investigate these securities.

A Handful of TRAKRs

There are five TRAKRs contracts on offer at the Chicago Mercantile Exchange.

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